Unit 1 ESSENCE OF ECONOMICS

Lecture 1

Prof. Prabha Panth. Osmania University

What is Economics

• Economics – from a Greek word meaning “household”

• Many definitions of Economics,o Starting with Adam Smith: An Inquiry into the

nature and causes of the Wealth of Nations.

o Alfred Marshall: Economics is the study of the ordinary business of life.

o Lionel Robbins: Economics is a science that studies human behaviour as a relationship between ends and scarce means that have alternative uses.

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Humans

Unlimited Wants

Limited Means

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Scarcity, Choice, and Allocation

• Scarcity: Limited resources -- unlimited wants, (D > S).

• Which of these wants should be satisfied? Question of choice.

• Exchange, which requires pricing.

• Limited means or resources have alternative uses also – e.g. should you buy a book, or go to a movie, or save your money? Allocation.

• Applies to both the individual (micro) and the entire economy (macro).

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Problems of an Economy

1) What to produce? Choice of goods.

2) For whom to produce? Choice of end users.

3) How to produce? Choice of technique

The above questions apply at both the

• Individual level (Micro) &

• Economy level (Macro)

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Macro Economics

• Entire aggregate economy.

• Policy recommendations – Normative Economics – how things ought to be.o Growth, planning, and development,

o Monetary, fiscal and international trade,

o Population growth, Employment,

o Inflation and deflation (trade cycles)

o Welfare includes: Removal of Poverty, Improvement in Health, Increase in Literacy, Providing housing, infrastructure, transport, etc.

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Micro Economics

• Deals with Individual economic units – consumer, producer, firm, labour, capital, etc.

• Analysis from the particular to the general, what is true for the individual is true for the whole economy.

• Neo-classical Economics, o Positive approach – analyse things as they are

o Perfect knowledge,

o Perfect substitution of K and L,

o Homogeneous goods and factors

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Basic building blocks of Microeconomics

• Partial equilibrium – all other things remaining constant (ceteris paribus), given by Marshall.

• Positive Economics, study of things as they are. No policy recommendations,

• Minimum or no role of the government (laissez faire)

• Static analysis – instant changes

• Deductive method of analysis.10-Apr-16 8

1. Rationality: Economic Man

Optimisation: All economic units want to optimise welfare – maximise benefits, minimise costs. Hedonism

o Consumer is rational – wants to maximise his utility, minimise expenditure

o Producer is rational – wants to maximise his profits, minimise costs

oWorker is rational – to maximise his wages, minimise work

o Capitalist – to maximise his interest, minimise capital

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2. Marginal analysis

• In Micro economics, all decisions are made at the margin. Optimisation.

• Margin – last or extra unit produced or consumed.

• Is the benefit from the last or extra unit its cost? If it is greater then more can be produced or consumed.

• If they are equal, then production/ consumption should be stopped. (More about this later).

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3. Opportunity Cost

• Limited resources have alternative uses.• E.g. a firm may invest in producing X or Y,

depending on which is more profitable.• If it invests in X, it cannot invest in Y or earn

profits from Y. Therefore Y is the opportunity cost of X

• Applies to all economic units – consumers, producers, and factors.

Opportunity cost: The next best alternative given up to undertake one course of action instead of

another.

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4. General and Partial Equilibrium

• General Equilibrium: Walras, Leontief:o Aggregate economy, Macro systems.o Interdependence – changes in one sector affects other

sectors,o Over all equilibrium of the entire economy.

• Partial Equilibrium: Marshall:o Individual units analysed, independent variables,o Other sectors in equilibrium (ceteris paribus)o Changes in one variable or sector, do not affect other

units or sectors, as the latter are kept constant by assumption.

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FALLACIES AND PITFALLS

UNIT 2

"Economics is haunted by more fallacies than any other science known to man."

-- Henry Hazlitt

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What is a fallacy?

• Deductive analysis is based on logical arguments or reasoning.

• If our arguments are correct, they will conform to the principles of sound reason, for which logic provides the formal rules.

• If our arguments are illogically due to violation of a formal rule of logic, or including false ideas, then –

• The argument is fallacious, and our conclusions will be false.

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FALLACIES IN DECISION MAKING

• If there are 10 economists there are 12 theories!

• Economic theory is based on assumptions, ideology, and analysis.

• Any or all of them could contain basic fallacies in argument.

• Since all aspects are not included in analysis, there are fallacies.

• Result - wrong conclusions and policies.

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1. Fallacy of Assumption:

• Many assumptions in Economic theory are not realistic: example:1. Rationality: irrational behaviour may exist.

2. Homogeneous goods: but goods are not so.

3. Full employment situation: unemployment is common

4. Perfect market: but monopolies dominate

So policies based on wrong assumptions, give wrong conclusions.

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2. Fallacy of subjectivity

• In spite of calling it “Positive Economics” there is subjectivity involved.

• For instance, assuming perfect competition is best.

• So interferences can be merely tentative hypotheses, subject to qualifications. If x then y.

• Conclusions from economic analysis: probabilistic (chances of happening) rather than deterministic (will happen).

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3. Fallacy of Composition

• What is true for the individual, is true for the aggregate! o 1 and 3 are odd numbers, so their sum must also be

an odd number. But 1+3 = 4 is an even number!

o If during a concert, one man stands up, he can see better. But if all stand up, no one can see anything.

o In Economics, if one man saves, it is good

o Keynes: if all save then recession occurs, as effective demand falls. Paradox of thrift.

o Fallacy between individual and aggregate actions.

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4. Post hoc and Propter hoc

• Post hoc ergo Propter hoc: “after this, therefore because of this." Usually called “post hoc”

• “Coincidental correlation" or "false cause,” assumes that if one event happens after another, then the first must be the cause of the second.

• Fallacy of conclusion based only on the order of events, not an accurate indicator.o Example: the cock crows before sunrise, then sun rises

Therefore the cock crowing results in the sun rising!

Most superstitions are based on such false reasoning and logic.

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5. Fallacy of Syllogism

• Form of logic, where there is a Major premise, a Minor premise, and a Conclusion.o For example: All men are mortal (Major premise)

The king is a man (Minor premise)The king is mortal (Conclusion)

But a fallacy occurs when we argue:A table has four legs.A dog has four legs,A table is a dog!

Necessary but not sufficient conditions.

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6. Fallacy of Black and White

• Binary - Two extremes, either “yes” or “no”,

• No middle ground – no “maybe”,

• Black or White, no Gray.

• But actual world consists of more gray areas, neither good nor bad.

• There is no such thing as "straightforwardly applying economic theory"...

• Application and policy depend on the social, political and cultural background of the economy.

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7. Broken Window fallacy

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• Acts of destruction cannot result in economic stimulus.

• Suppose a ruffian breaks a baker’s window.

• People say, “Baker has to buy glass to repair window.”

• Creates income for the glazier, who in turn will spend it on fruits, and it will go on, infinitely.

• There will be employment and income created.

• So breaking the window is a good thing for the economy!

The fallacy

• But the baker may have wanted to buy something else with the money (opportunity cost), say a new suit.

• Now he has to get a new window, but no suit.

• If he had bought the suit income to tailor, who would have spent it on buying a TV, and it would go on,

• Now the glazier’s gain in business, is the tailor’s loss!

• If the ruffian had broken all the windows of all the shops, does it lead to greater economic good?

• Does spending on war, lead to greater economic good? What about the costs of human life, suffering and distress?

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Thank you

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